Rule of Constructive Receipt

MR. WATSON: Remember, in 1988 congress changed the tax law so that any policy endowing before age 95 is taxed.

MR. WATSON: There's something called the "rule of constructive receipt". If you have the ability to take your money because it endowed-then we're going to tax you on that money, even if you didn't take it. So you might as well go ahead and take it. The IRS says if you have the ability to take the money, because it endowed, then we are going to tax you as if you took it, so you might as well go ahead and take it. Now, follow me with this example. If a policy was about to endow, before age 95, and cause a tax situation, many people might say, "Okay, my policy endowed. I want to avoid the taxes. I'm not going to take the money." Don't send it to me.

STUDENTS: Yes.

MR. WATSON: So under the "rule of constructive receipt", it says if you CAN take the money, (because it endowed), we're going to tax you as if you took it, so you might as well go ahead and take it. But, you have 60 days to roll it over into an annuity option before this rule takes affect. This would allow you to spread your gains over a longer period of time. This is assuming the policy endowed before age 95.

MR. WATSON: Again, in 1988 congress changed the tax law so that any policy endowing before age 95 is taxed. So, for instance, let's take an interest sensitive whole policy. The interest rate goes up and we choose to pay the same amount of premium, letting this higher interest rate affect the cash values. Making them grow faster. In this example the policy could endow before age 95. You would be taxed on the gain.

MR. WATSON: How can I tap my cash value without paying taxes? By borrowing the money. Canceling (cashing in) the policy could create a taxable gain.

Determining Cost Basis ***

MAN: But if you have a $100,000 policy and its cash value is up to $7,000 and you cash it in, do you have to pay taxes on it?

MR. WATSON: It depends on how much you paid in, less policy dividends. That's your cost basis.

MAN: Okay.

MR. WATSON: So we'd add up all your premiums and subtract your policy's dividends because your dividends are return of premium.

MR. WATSON: Does that make sense?

MR. WATSON: Looky here. You are paying premiums of $1,000, paying for 10 years. Total dividends paid by the company have been $2,000. You cashed it in for $15,000. Got it?

WOMAN: Yeah.

MR. WATSON: I want to know two things. I want to know my cost. And I want to know my gain. You paid in a thousand dollars for ten years, dividends are $2,000. Got it?

MAN: Doesn't make any sense.

MR. WATSON: Makes perfect sense.

MAN: If you paid in a thousand dollars a year for ten years, dividends of $2,000, so you are talking about 12,000. Where did $15 come in?

MR. WATSON: Look guys, when you buy a whole life policy, you create cash value. That cash value is earning interest.

MR. WATSON: Tell me where you all are getting screwed up. It is this simple. You paid in a thousand dollars a year; you have dividends of $2,000. How did we get so much cash? Because the cash value is invested and it's earning interest. Do you agree?

ALL: Yes.

MR. WATSON: So sometime in the whole life policy you will get back more than what you paid in, as you see here.

WOMAN: So my cost was $12,000 and my gain was three grand?

MR. WATSON: I'm going to the bar.

(Laughter.)

MR. WATSON: I'm just asking. Guys, what's my cost basis?

ALL: $10,000.

MR. WATSON: No. Heavens, no! What is the definition of a dividend?

WOMAN: Return of premium.